A Rising Dollar Sparks Mood Shift for Stocks

By

Michael Kahn

Updated May 23, 2011 12:01 a.m. ET

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A combination of factors led by a strengthening U.S. dollar has put stocks on shaky ground. For the second year in a row, it seems that the old saw, "sell in May and go away," could turn out to be good advice for investors.

Over the past year, the Standard & Poor's 500 has usually moved inversely to the U.S. dollar index. As the greenback fell, stocks usually rallied. And when the dollar bounced, stocks struggled a bit.

The inverse correlation can be seen quite clearly by comparing the stock chart over the past 12 months of the S&P 500 stock index with the
PowerShares DB USD Index Bullish fund
(ticker: UUP), an exchange-traded fund which is a proxy for the U.S. dollar versus other major currencies. The two charts look like mirror images of each other.

So when the dollar index made a technical breakout two weeks ago, stock market bulls were put on alert. Over the past two trading days, the dollar surged again to confirm that something is indeed different in the currency - and by extension in the stock market.

But a stronger dollar is not the only factor suggesting that stocks have at least stalled. A chart of the S&P 500 with a longer-term view shows several factors working against stock-market bulls right now (see Chart 1).

Chart 1

STANDARD & POOR'S 500

The first important feature on the chart is the change in the technical indicator called "relative strength index." This is a measure of the overall interest by investors in chasing prices higher. Healthy markets sport strong readings in the indicator.

After the March pullback, price action moved up to set fresh new highs, but the indicator did not. This divergence between the two is a warning. And more times than not it is price action that turns to follow the indicator.

A second feature on the chart is the subtle shift in mood that occurred during the week of May 2. The S&P 500 rallied to a fresh new high at 1370 - its highest level in nearly three years - before reversing course.

When an index makes such a new rally high and then closes for a net loss on the week it signals a change of attitude occurred.

Since that time, all major indexes fell below key levels on their respective charts. And the upside breakouts seen last month in many of them are no more. In technical analysis theory, failed bullish signals tend to become bearish signals going forward.

One factor not on index charts is the state of leadership among the various sectors in the market. Financial and technology sectors lagged the broader market all year and that is usually not a healthy sign for a bull market.

Even superstar stocks, such as
Apple
(AAPL) and
Netflix
(NFLX), have stalled. Neither has made any net gains in several months after enjoying market-crushing multiyear run-ups.

The sectors that are in the lead - health care, food, tobacco and utilities - are all considered to be defensive. In times of duress, investors stick with stocks of companies that enjoy relatively inelastic demand for their products. People are more likely to postpone a vacation purchase than forego their food and medicine.

Therefore, a shift towards these sectors in the stock market signals heightened levels of anxiety among investors. And that means they are more likely to sell their stocks on news that would have been ignored in better times.

The changing internal mood of the market and shifting leadership from aggressive to defensive areas suggest that stocks are in a different place then they were over the past few months. A rising dollar, at least for now, provides the technical push for this month's weakness as the market kicks off its traditionally less favorable summer season.

Getting Technical Mailbag:Send your questions on technical analysis to us at online.editors@barrons.com. We'll cover as many as we can, but please remember that we cannot give investment advice.

Michael Kahn, mutual fund co-manager, author of three books on technical analysis, former Chief Technical Analyst for BridgeNews and former director for the Market Technicians Association, also blogs at www.quicktakespro.com/blog.

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